Credit ratings are primarily backward looking, so they do a better job of explaining why a bond’s price has moved in the past, than predicting future price movement. However, this does not mean they are not useful to bond investors, and especially to individual investors.
An investor should only make investments where they are comfortable with the level of the risk. In other words, just because a junk bond offers a higher yield to compensate for the higher level of risk, does not mean that an investor should own junk bonds. Credit ratings are very good at measuring default risk, so looking at the credit rating of a bond or bond fund in combination with default rates, gives investors an easy way to decide how much risk they are comfortable taking.
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The following table shows the starting rating of a bond, and the expected default rate over a period of 10 years. (data from Standard & Poors for 1981 – 2011)
||10 Year Default Rate
Don’t know what the letters mean? See our credit rating table here.
When using the above table to think about the level of risk that you want to keep in mind
- Most default data tends to look at default rates for holding a bond of a particular rating for a single year. However, as ratings change over time and investors hold bonds over a period of years, looking at this typical measure does not provide much clarity in regards to the chances a bond is going to default over longer holding periods. This is why we are giving you cumulative rates for 10 years.
- Because these are 10 year default rates, the rate in any given year will be from around 1/10 the number for the highest rated bonds to ½ that number for the lowest rated securities.
- As you move from one letter grade to another, the increase in the historical default rate is not linear. The default rate for AAA and AA are very similar. The default rate from AA to A is more than doubles. The default rate from BBB to BB triples.
- If you are buying individual corporate bonds and not investing through a fund, a conservative investor might be willing to hold only A rated bond (AAA, AA, AA). A more risk tolerant investor might be willing to buy BBB rated. Anything lower rated is extremely speculative and probably be limited to less than 5% of one’s portfolios.
This lesson is part of our Free Guide to Investing in Corporate Bonds. Continue to the next lesson here.
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